I started my career on Wall Street where I spent several years thinking about how to build balanced portfolios of financial securities. One important lesson I learned early on is that picking the right mix of stocks, bonds, real estate, and other assets is the difference between average and stellar returns. Put differently, the most thoughtfully constructed portfolios generally produce the best return on investment.
Later, after I’d started building companies, it dawned on me that customer and investment portfolios share a number of similarities. This led me to the discovery of a book by Don Peppers and Martha Rogers, called, Return on Customer. They wrote it to help managers learn how to quantify how well their company creates value from its pool of customers.
Return on Customer (ROC) is a valuable tool that companies can use to evaluate their efficacy in creating and sustaining customer equity. In this post, I’ll share some of what I learned from their book and my own experience of implementing programs to measure and improve ROC.
So how exactly is a portfolio of customers like a portfolio of stocks and bonds? Well, take a moment and imagine you want to calculate the return on investment (ROI) for your personal portfolio for the last year. ROI is simply the ratio of your profits for that period divided by the cost of your investments. By way of example, suppose you invested $1,000 a year ago. At the end of the year, you received $100 in dividends and interest. During that time the underlying value of the investment also increased to $1,150, resulting in a total profit of $250. Divide $250 by $1,000 and you get an ROI of 25%. Voila!
Now suppose someone told you to ignore the change in the underlying value of your securities and only focus on the interest and dividends you received. Run the calculation again and you get a 10% ROI ($100 / $1,000 = 10%). Does that reflect the true picture of your financial return? Of course not. In this case, looking at the world through this lens grossly misrepresents the value of your portfolio.
But this is exactly what happens all the time inside companies. Most companies are laser focused on growing recurring revenue and reducing churn. These changes are part of the driving force behind customer-centric vs. customer-focused business models.
However, we often examine the “dividends” we receive from a basket of customers for a given period of time but ignore any increase or decrease in the underlying value of our relationship with them. Just as a portfolio of securities is made up of individual stocks and bonds that produce income and fluctuate in value, so too does a company’s portfolio of customers.
So, despite the fact that management and customer success teams have become really good at measuring revenue, upsells, and upgrades - the dividends paid by their portfolio of customers - most still haven’t made much progress in evaluating the changing intrinsic value of each of their customer relationships over time. I’m simplifying a little, but Peppers and Rogers define this underlying value as customer equity, or the sum of the expected Lifetime Value (LTV), of all of your customers.
Customer equity in ROC is akin to the initial value of an investment in the ROI equation we looked at earlier. ROC is calculated by taking your company’s current-period cash flow from its customers plus any changes in the underlying customer equity, divided by the sum of all customer equity at the beginning of that period. You can also perform the same calculation for any individual customer relationship.
The important point here is that customer equity, which is made up of the total expected lifetime value of your customers, fluctuates over time the same way the value of the Apple stock in your portfolio does. Just as the price of Apple stock increases and decreases based on the market’s perceived value of its business, your company can experience increases or decreases in the value of its customer equity based on the expected lifetime value of your customer relationships.
Return on Customer thoughtfully takes into account the two primary ways customers create value for a business:
By increasing the company’s current period cash flows (upgrades and upsells)
By increasing its future cash flows through higher expected lifetime value. Measuring ROC helps you to quantify the potential impact of increasing customer happiness, reducing churn, or driving more referrals.
Looking at your company’s ROC from the top down can help clarify its medium to long-term prospects in ways that traditional financial reporting is unlikely to reveal. But to understand your company’s aggregate Return on Customer, you also need to understand your ROC on a customer by customer basis. To illustrate my point, take a look at the table below. It contains information from four customers of mine from a previous life, divided into three categories depending on whether each one was creating, harvesting, or destroying value.
In this example, customers A and B are categorized as Value Creators. In each case, the combination of the short and long-term value they added to the company was significant. They both ended the period in question with a higher customer equity value than they started with. In customer B’s case, the total customer value was higher at the end of the period despite the fact that we lost money on them during that time!
The reason we failed to make an economic profit on this customer was because we chose to invest aggressively in the relationship by spending a large amount of time doing a bunch of work for that customer that we were confident would result in higher expected lifetime value. That customer appreciated our commitment and helped us to win several new customers during that period and ended up spending significantly more on our products after we finished those projects.
Customer C is what Peppers and Rogers call a Value Harvester. We made a very small economic profit on them during the period and their expected lifetime value also increased marginally. Because we were basically treading water with this customer, we assumed, accurately, that we were unlikely to be able to grow the account significantly in future periods. Of course, that didn’t mean we treated them any differently or asked them to seek a different service provider. On the contrary, we continued to nurture and support the relationship. However, knowing there wasn’t much upside from current levels helped us to free up more of our scarce resources to invest more aggressively in other, more promising customer relationships.
Lastly, Customer D was very clearly a Value Destroyer. Not only did we not make an acceptable economic profit from the relationship during the period, but the underlying value of their customer equity also fell. In this case, we went to the customer 90 days before their contract was set to renew and let them know it was time to reevaluate our business relationship.
When reviewing the performance of your investments, cutting your losses and investing more in your winners is a good way to earn healthy returns. The same is true of your portfolio of customers. The truth is that like investments, not all customers are created equal. In both cases, some simply aren’t worth the time or financial investment required to keep them around.
In order to figure out which relationships matter most over time, companies need to measure both the changes in the underlying asset value of each customer and the revenue they are receiving from them. Knowing these things is paramount to understanding the return you are getting on your investment in your existing customers and their true profitability. Once you know this, it is much easier to make decisions about when, where, and how to allocate resources across your customer portfolio to build better relationships.
Companies live and die by the profitability of their best relationships in much the same way as investment portfolios live and die by their best investments. Using ROC to identify and weed out Value Destroyers while working to turn Value Harvesters into Value Creators is a sure fire way to the continual growth and success of any business.